In the quarter century or so I have spent studying the Pakistani economy I don’t believe I have seen the country faced with such difficulties as it does today.

The reason why the situation is so grim at this time is that a number of adverse developments have come together. What we see on the horizon is the building up of a perfect storm.

What is coming together is a fiscal situation that is not sustainable; a balance of payments crises that threatens bankruptcy and possible default on some foreign obligations; a sustained increase in domestic prices, particularly for the goods and commodities that affect the incomes of the poorer segments of the population; and, finally, a serious problem in the supply of two important energy products, electricity and natural gas. In the article today, I will focus on one part of the problem – the bad and worsening fiscal situation.

Pakistan has been in fiscal difficulties before. The country is vulnerable since there is a large gap between what the government raises as revenues and what it spends on development, defence and non-development obligations of the government. This gap has remained at about the same level – at about four to seven per cent of GDP. This gap becomes a major threat to financial stability if it is covered by the state through bank borrowing. This has happened in the last couple of years which is one reason why the rate of inflation has picked up palpably. To the push to the level of prices from the government’s approach to meeting the deficit has been added the push given by the sharp increase in commodity prices, including the price of oil and food grains, to produce destructive inflationary pressures in the economy.

There is one other problem associated with large fiscal deficits. They increase domestic demand which, in turn, has an adverse impact on the balance of payments. Imports increase beyond the capacity of the country to finance them. This means a constant drain of foreign exchange reserves. This is happening now at a rate which would create a serious external finance problem. The numbers keep changing but at the moment usable reserves are down to $5 to $6 billion. Monthly net payments are about $ 1.5 billion. This means that the country will be out of reserves in about three to four months. Will the present set of policymakers be able to deal with the crisis?

The prime minister during his recent visit to the United States took pride in the fact that the administration he heads was able to increase the price of oil four times in three months. This was a difficult move by a newly elected government concerned about its popularity. Had oil and petroleum prices not been increased they would have further added to the fiscal problem by increasing the amount of subsidies and their proportion in total public sector expenditure. The new government has also increased the price of electricity to reflect price increases for the fuels that are used for generation.

These are good moves but they don’t constitute a strategy required for bringing about structural changes in the system. For that, the government has to move simultaneously on four fronts. The first is improving tax administration which in spite of the repeated efforts over the last several decades remains weak, inefficient and also corrupt. I have seen estimates that suggest that the leakages out of the tax system are equivalent to four to five per cent of GDP. If these were to be successfully plugged, that alone would raise tax to GDP ratio by one-third, to 14 percent of GDP. The World Bank and the IMF have advised the previous administrations and also provided finance to improve the efficiency of tax administration. That hasn’t helped as can be seen from the accompanying table which shows a decline in tax to GDP ratio rather than an improvement.

The second area of public policy concerns government expenditure. This is usually divided into three broad categories – development, non-development and defence. Two of these three need to be constrained; the only one that should increase is the expenditure on development. Two to three decades ago, the country spent much more on development as a proportion of GDP than it does now. This is one reason why Pakistan has lagged so far behind several Asian countries in terms of social development. While the private sector can play an important role in providing education and healthcare to some segments of the population, the poor have to be taken care of by the government. That means increasing the proportion of public expenditure in GDP.

In so far as the expenditure on defense is concerned, Pakistan will have to reconfigure its expenditures to reflect the changes in the environment in which the country currently operates. For nearly six decades, Pakistan had what is best described as an India centric policy; preparing to defend itself against India. Starting from a relatively weak position, the country was able to build its military strength largely because of American support.

The United States had its own reasons for building the country’s military; it was not done to protect it against any possible hostile intentions on Delhi’s part but to serve American interests in the area. Given that India and Pakistan followed very different economic growth strategies since the mid-eighties, it has become very expensive for Islamabad to continue to balance New Delhi’s growing military might.

Islamic extremism now is a greater threat to Pakistan’s security than India’s growing strength. It is, therefore, appropriate to ask the question as to what should be the size of the military, how should it be equipped, how should it be trained, what kinds of alliances should be formed with the military’s in the region in which the country is located. Such a reformulation of the defence strategy should lead to a reduction in the expenditure on defense as a percentage of GDP. Whatever is saved should be directed towards social development.

Recurrent, non-development expenditure is the third category of government spending that needs to be carefully reexamined. There is a great deal of waste here in part because of the poor over-sight by the legislature and the judiciary on the executive.

Also, the failure to abide by the promises made to the provinces in 1973 when the present constitution was adopted has meant considerable duplication of work at the federal and provincial levels. If this type of expenditure is scrutinised the government may be able to save a couple of percentage points of GDP. This could be used to reduce both the fiscal deficit as well as increase the expenditure on social development.

The third area of reform relates to the design of tax policies. In addition to improving tax administration, tax policy also needs to be revised. At least three changes need to be made. The better-off people need to pay their due rather than use tax loopholes or bribes to reduce their obligations.

Finally, the government should allow greater fiscal autonomy to the provinces. The federating units should be allowed greater authority to tax their citizens and the properties they hold in their jurisdictions. The proceeds from these taxes should be spent on development in the provinces. Provincial tax returns should not be allowed to be expended on non-development activities.

These policy changes will reduce fiscal deficit and create fiscal space within which to accommodate more expenditure on development, in particular on social improvement. These approaches have been tested in many countries and have yielded positive results. What is required is political will on the part of those who now govern from Islamabad to adopt them in Pakistan as well.